The fear of an impending recession has grown recently as inflation persists, interest rates rise, global supply chain disruptions linger, and commodity price volatility continues amid the war in Ukraine.
Add to this a roster of privately funded middle-market companies with over-levered balance sheets that swelled during the last 18 months’ easy money environment, and it is plain to see that providers of private capital should prepare themselves for a U.S. economic down cycle and uptick in Chapter 11 bankruptcy filings.
Some of this distress has already risen to the surface as MacAndrews & Forbes-backed Revlon, Inc. filed for Chapter 11 on June 15, 2022 in the U.S. Bankruptcy Court for the Southern District of New York.
As a result, private equity sponsors and private credit lenders should keep several principles about Chapter 11 bankruptcy in mind to ensure that they are best positioned to maximize value in the event that a portfolio company experiences financial distress.
Providers of private capital should prepare themselves for a U.S. economic down cycle and uptick in Chapter 11 bankruptcy filings.
Out-of-Court Restructuring Trumps Chapter 11
Chapter 11 is a court-supervised process whereby a company can restructure its liabilities (e.g., debt, litigation liability, vendor and customer claims) and reorganize as a healthy going concern. Chapter 11 also allows a company to sell some or all of its assets free and clear of liens, claims, encumbrances and most successor liability claims.
Despite Chapter 11’s benefits, if a sponsor-backed company experiences financial distress and the board determines upon the advice of counsel that a restructuring of the company’s debt and other obligations is necessary, the company should seek to find an out-of-court solution before pursuing Chapter 11.
There are several reasons why companies, lenders and sponsors might want to avoid Chapter 11 and restructure out of court.
First and foremost, an out-of-court restructuring is typically quicker and cheaper for the company and its lenders than Chapter 11.
In addition, in Chapter 11, the company must provide detailed disclosures to the bankruptcy court about its financial position and pre-bankruptcy conduct, which can be burdensome and invasive.
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Finally, and perhaps most important from the perspective of private capital providers, existing equity is frequently cancelled in Chapter 11 and funded debt holders often have their rights modified without their consent. Following its emergence from Chapter 11, the portfolio company has no obligation to make old creditors and equity holders whole again.
In most circumstances, therefore, private capital providers and their advisors should work with the distressed company’s advisors to avoid Chapter 11 to the extent possible. The best way to do that is through proactivity. The sooner the company, its sponsor and all of its affected lenders are able to retain professionals and start engaging in substantive discussions around the terms of a deal, the better off all parties are likely to be as it will ensure that there is enough time to explore all value-maximizing options.
For this reason, private credit lenders should consider whether to temporarily forbear their right to exercise remedies in the event of a debt-document default to buy the parties time to negotiate a mutually beneficial out-of-court deal.
In addition, given the time and attention involved in doing so, the distressed portfolio company should strongly consider directing its advisors to prepare the pleadings and perform the requisite due diligence to file for Chapter 11 should it become necessary. This will not only avoid a haphazard bankruptcy filing, but it will allow the company and its equity sponsor to incentivize a consensual deal that leaves old equity holders in place. It does so by credibly threatening to commence a Chapter 11 case that would leave lenders with a recovery that pales in comparison to the one they might have received through a consensual, out-of-court restructuring.
Reorganization via Chapter 11
In some cases, however, a voluntary Chapter 11 filing is unavoidable. Even in the private credit context in which covenant-lite loans make it less likely that a portfolio company will trip a debt document covenant, a company may simply run out of cash and need to file for Chapter 11 to obtain bridge financing. In other situations, even if a junior non-bank lender is willing to consent to an out-of-court deal, senior lenders may not be so agreeable. In that case, without unanimous lender consent for an out-of-court deal—which is typically required under most corporate debt documents—a company may need to file for Chapter 11 to obtain bankruptcy’s automatic stay of adverse creditor action.
From a distressed portfolio company’s perspective, Chapter 11 provides several key benefits that are intended to facilitate its reorganization.
First, under certain circumstances, a Chapter 11 debtor can force its restructuring plan on creditors against their will even if those dissenting creditors do not receive a full recovery. In addition, due to special protections the law extends to lenders that provide bankruptcy financing, it may be easier for a company to obtain a liquidity lifeline in Chapter 11.
A company can also shed unprofitable contracts and leases (e.g., those based on commodities prices that differ from the current market price) and leave the counterparty with an unsecured claim that frequently is not paid in full.
Actively Participating in a Portfolio Company’s Chapter 11 Case
Just because there are circumstances in which equity sponsors and private credit lenders may receive little to no recovery in a portfolio company’s Chapter 11 case does not mean that they should not actively participate in the process. Indeed, just the opposite is true.
Just because there are circumstances in which equity sponsors and private credit lenders may receive little to no recovery in a portfolio company’s Chapter 11 case does not mean that they should not actively participate in the process.
For example, with the assistance of skilled advisors, junior lenders or equity holders that are partially “in the money” may be able to acquire equity in the reorganized company on account of their claims and interests. It is also not uncommon to see a Chapter 11 debtor issue new securities on favorable terms to pre-bankruptcy equity sponsors and lenders if they are willing to put in new money.
In addition, equity sponsors and lenders may each be able to obtain valuable releases from certain claims and causes of action held by the company and third-parties. It is common that a Chapter 11 restructuring plan provides for releases of a company’s officers and directors, private equity sponsor and its consenting lenders. This is an incredibly important protection for private capital providers should other parties-in-interest threaten to bring fraudulent transfer claims against the fund in connection with, for example, a pre-bankruptcy leveraged buyout or dividend recapitalization transaction.
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Similarly, these same parties may also threaten to bring actions based on alleged breaches of fiduciary duties by board members affiliated with private capital funds that have invested in the company. In a relatively consensual restructuring in Chapter 11, these claims are frequently released as well.
The foregoing discussion is merely intended to provide private capital providers with a brief introduction to some of the most important principles of Chapter 11. It is not intended to be the last word on bankruptcy or to replace the advice of experienced restructuring counsel. Hopefully, however, the principles discussed above will help funds avoid being caught flat-footed when the next recession does eventually arise.
Bryan V. Uelk is a member of Sheppard, Mullin, Richter & Hampton LLP’s Finance and Bankruptcy team. He represents companies, creditors, distressed purchasers, and other key stakeholders in all aspects of corporate restructuring, bankruptcy, and financial distress. He has substantial experience guiding clients to value-additive results in out-of-court and in-court restructurings, including in numerous chapter 11 reorganizations across the country. Bryan also served as a JAG officer in the Air National Guard for several years, during which he advised commanders at both the Wing and Squadron level with various personnel actions and provided all types of legal assistance to Airmen and their families.